Many investors are under the impression that bonds are automatically safer than stocks. After all, bonds pay investors a regular fixed income, and their prices are much less volatile than those of stocks. But these positives are only part of the story. In many cases, bonds can be much riskier than stocks for investors, adding exposure to reduced purchasing power and the ravages of inflation.

A key fact in this complex picture is that bonds are high-risk investments for the issuing company, while they're low-risk for investors. Conversely, a stock is low-risk for the issuing company, but it's high-risk for investors. So who are bonds safer for? And what even is a bond?

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What are stocks and bonds?

To grasp why bonds can be both safer and riskier than stocks, it's key to understand exactly what each asset is. A company has two major ways to raise money to fund its business: issuing stocks and issuing bonds. Each method carries certain obligations and responsibilities, and in each case, the interests of the company usually differ from those of its investors.

What is a bond?

Bonds promise investors a fixed interest payment over the life of the bond and then a return of the original principal. For investors, bonds offer a relatively safe payout: The interest must be paid, or else the bonds go into default, which allows the bondholders to garnish the company's assets. By law, companies must distribute any cash that's owed to bondholders before stockholders can receive a cent. For companies, though, bonds are a relatively risky way to fund operations. Management must meet interest payments on a timely basis, or investors can take the company's assets in payment of the debt. It's a sharp contrast to what companies must pay stockholders: zero.

In exchange for the money they lend a company by buying its bonds, investors can also demand certain restrictions -- called covenants -- on how that company can use its own money, and how much debt it can assume. Covenants prevent the company from spending its cash recklessly. If the covenants are breached, bondholders may be able to demand payment on their bonds.

What are stocks?

Stocks offer investors an ownership stake in the ongoing profits of the business, but there's no promise of a payment. For investors, stocks are relatively riskier because they don't provide any contractually obligated payouts at all (though the company may decide to pay a dividend). The value of the investment fluctuates based on the business's profits and whether investors are confident in the company's future.

For companies, stocks are a safer way to fund the business. Because stocks don't require any payouts, a debt-free company can operate without fear of going bankrupt or having its assets seized. While investors might expect some kind of return for their dollars, the company is under no obligation to provide one. However, the stock of a well-run company with growing profits will tend to rise, offering investors a capital gain.

This table summarizes some of the key differences between stocks and bonds:

Characteristic

Stocks

Bonds

Required payouts

No (though dividends may be declared, or stopped, at any time)

Yes

Volatility

High

Minimal to low

Potential upside

The sky's the limit

Fixed and relatively low

Potential downside

Can lose everything

Can lose everything, but can often recover at least something from company's assets

Ownership stake in the business

Yes

No

What are the benefits to buying stocks and bonds?

Stocks and bonds each provide different benefits, and investors may prefer one or the other for different reasons. Bonds usually offer lower returns but greater safety, while stocks usually offer the potential for higher returns in exchange for the investor assuming higher risk.

When investors buy a bond, it's a straightforward contract in which every payment is spelled out beforehand. The company knows what it's going to pay, and the investors know what's going to be paid, over the life of the bond. Even in the case of bonds with floating (as opposed to fixed) interest rates, the details of the payout are certain even if the exact amount fluctuates. That certainly reduces risk, as does the ability of bondholders to make a claim on the company's assets if interest is not paid.

So investors like bonds for their greater certainty and more certain returns. But the higher level of assuredness also means that the potential gain for bonds is lower. That's because lower-risk assets usually come with lower returns. Investors want to be paid for any extra risk they're assuming when they invest. Otherwise, they'll be loath to hand over their money. And this is where stocks come in: Because they're riskier, investors demand a higher return.

Potential for higher return is one appealing factor for stocks, but it's not the only one. Stocks have the potential to soar over time because they represent an ownership interest in the business -- a claim on the company's profits. As profits climb over time, ownership of some of those profits becomes increasingly valuable, and the sky's the limit on how much gain can be realized. Companies such as Apple and Amazon surpassed the trillion-dollar threshold, bringing investors who held them for years huge fortunes.

Stocks can also allow investors to increase their purchasing power over time. On average, the total average annual return of the S&P 500 has been about 10% (including dividends). That's much higher than the level of inflation in the U.S. -- typically between 2% and 3% each year. Stock investors gain purchasing power over time, meaning they can buy more things and enjoy greater overall financial security, and robust retirements.

Some stocks also pay dividends, doling out cash payments to investors on a regular (typically quarterly) schedule. This cash is an incentive for investors to hold the stock, and the best companies have grown the dividends they pay for decades. The appeal is clear: a growing stream of dividend income, in exchange for simply holding the stock over time. Among the best dividend stocks are what the S&P calls Dividend Aristocrats, which are S&P 500 stocks with a track record of increasing dividends at least once a year for the past 25 years. Investors, especially those who need reliable income like retirees, tend to flock to dividend stocks.

In the U.S., companies generally prefer to maintain a regular, sustainable dividend rather than paying out a percentage of their profits. That keeps payouts steady and rising instead of fluctuating with profits, which can dip substantially during a rough patch. Some of the most popular dividend stocks include real estate investment trusts (REITs) and master limited partnerships (MLPs).

What are the disadvantages of stocks and bonds?

All investments are not perfect across all scenarios. Stocks and bonds alike have drawbacks, if only because neither solution can always meet investors' needs all the time.

Perhaps the biggest drawback for bonds is that the potential for upside (profit) is limited. Generally, you're never going to earn more income on your investment than what is contractually promised in the bond. So capital gains are a smaller part of the overall return with bonds than with stocks. Sure, you may be able to buy discount bonds or distressed bonds to earn substantial capital gains, but you'd be taking on much more risk.

Since your upside is generally limited to this contractually guaranteed stream of payments, bonds often return little more than the rate of inflation -- and that's the most growth your purchasing power will see, too. For example, high-quality corporate bonds might yield 4%, while inflation runs at 3%. That's a meager gain in purchasing power over time, and you wouldn't have been much better off if you had held the money in cash. If inflation rises above 3%, you could lose real purchasing power, in addition to seeing the value of your bond decline. That's a sharp contrast to stocks, which collectively provide much better returns than inflation.

Even worse, while the upside of a bond is limited, the downside can still go all the way to zero. It's possible to lose all your principal investment amount if the company goes bankrupt and there's nothing left to pay the bondholders. That's an unusual scenario, but it does happen from time to time.

There are several disadvantages for stocks. First, there's zero guaranteed return. If a stock doesn't pay a dividend, you must rely on the stock's price to rise in order to get any return at all. Even if a company does pay a dividend, the amount could be cut; it's never promised. And that's most prone to happen when investors need the money the most -- during a recession when times become tougher for everyone. When a company cuts its dividend, investors can expect the stock price to drop quickly, in a double whammy of lower cash payout and a capital loss.

Unlike bonds, stocks tend to be quite volatile; it's not unusual for a stock's price to fluctuate by more than 50% in a single year. Owning stocks requires nerves of steel, and that's especially true during recessions, when individual stock prices can plummet even more sharply. Of course, smart investors know that when stocks are cheap, that's exactly the right time to be out in the market buying them -- that's how we secure great returns.

Are bonds riskier than stocks?

Just because stock prices fluctuate more than the prices of bonds doesn't mean more risk for the investor -- at least not in all scenarios. In fact, there are plenty of times when bonds can be more risky than stocks.

Here's how they match up in a few common situations:

  1. In a highly inflationary environment: If inflation is rising quickly and the central bank does nothing to deter it, the price of bonds can be destroyed. That's because bonds are entitled to an agreed-upon stream of payments, and if inflation erodes away the value of those payments, the bonds become much less valuable. (In countries that allow inflation to rage unchecked, they can become worthless.) Companies end up repaying their debts in much less valuable dollars. In contrast, the stocks of companies that can raise prices during an inflationary environment can do well. By raising prices, they grow their own profits, boosting the value of their stock, perhaps even above the rate of inflation. So while bond prices might get crushed, the stocks of well-managed and well-positioned companies may continue to rise. In this scenario, bonds are much more risky than stocks.
  1. In a moderately inflationary environment: Even in a moderately inflationary environment, bonds can be surprisingly risky. That's because bonds don't offer enough of an increase in real purchasing power -- that is, their interest rates are not high enough over the inflation rate. So, despite saving diligently, investors who invest only in bonds may not have enough purchasing power when they retire. In this scenario, while bonds look safe because they provide a secure return, they're actually exposing investors to lower purchasing power than they otherwise could have had with higher-return investments such as stocks. In a world where inflation is always chipping away at purchasing power, investors need to earn an adequate return. In this scenario, then, bonds create a less obvious risk, but one that should be taken seriously.
  1. In a market sell-off: In this scenario, stocks tend to be much more volatile than bonds. Stock prices often decline precipitously even as bonds become more valuable, perhaps because investors believe interest rates may be declining in the future. It's a bad time to be a seller of stocks, so if you can wait for a rebound, you'll generally see a substantial bounce back in price within a few years. In this scenario, bonds tend to be safer because their prices are more stable. After a market sell-off can be a good time to buy stocks for the long term.

When does it make sense to own both stocks and bonds?

It can make sense to own stocks and bonds in all stages of the market cycle, because a diversified portfolio smooths out your returns and creates less volatility. In addition, a diversified portfolio allows investors to take advantage of times when stocks are cheap and bonds are dear (during recessions), or when stocks are expensive and bonds are on sale (during the last stages of a bull market). Investors can trade stocks for bonds, or vice versa, allowing them to make use of price declines in one asset class or the other.

Professionals generally recommend younger investors who have a long investment horizon invest more aggressively with stocks, because they tend to do much better than bonds over time. That may mean a portfolio that is comprised completely of stocks, since their long-term returns are so much better. Some advisors tell these investors to buy growth stocks, which tend to be more volatile but also often deliver higher returns over years. A long time horizon allows stock prices to decline and recover while still providing an attractive return in the end.

As investors near retirement, though, it makes sense to shift their portfolio toward bonds, which have less volatility and a finite lifespan. Nobody wants to be wiped out during a market sell-off when they're so close to retirement, and bonds offer a better safety net over short investing horizons.

As investors enter retirement and thereafter, they usually move more of their assets to bonds, while leaving only a little in stocks (or none at all). This approach provides them with a more stable income stream during a stage of life when they may not be able to afford a substantial decline in their investments. Some retirees may even opt for an all-bond portfolio, accepting the trade-offs that make it sub-optimal in a highly inflationary environment.

Because stocks are more volatile than bonds, professionals recommend that you only buy stocks with money you can commit for at least three to five years; it may require a period that long for a stock's price to recover from a decline. In contrast, bonds' shorter duration and their guaranteed return of principal make them more suitable for folks who need the cash sooner, like retirees.

Sometimes bonds are riskier than stocks

The big lesson here is that while many investors think of bonds as a "safe" asset, there are some scenarios in which they can be quite risky. In certain cases, stocks can be the more secure option! So it's important to understand that there is not an absolute, and that each investor must choose solutions to fit their needs and lifestyle. If you have enough principal amount invested, you can opt for a bond-heavy portfolio, but if you need a bigger nest egg, you may want a greater allocation to stocks in order to capture the growth of the market and supercharge your savings.

Many investors buy both asset classes for the purposes of diversification, allowing them to take advantage of the benefits of each while mitigating all the downsides. Then, they can then change how much they hold of each asset based on their changing needs over the course of their whole lives as investors.